The legal and process issues relating to the

formation of contracts

This podcast gives an overview of the legal and process issues relating to the formation of
contracts.

This section looks at the issues relating to the formation of contracts and the associated risks.

For an offer to be valid it needs to be an expression of willingness to enter into a contract on

specific terms, and an intention for the contract to be binding once it is accepted. There are
subtle but key differences between an offer and an invitation to treat. An offer is specific to an
individual person whereas an invitation to treat is broader and can be advertised to the world at
large, for example, a car advertised on a website.

A counter offer is an offer made in response to a preceding offer, which changes at least one
key element of the preceding offer. A request for more information to clarify an offer is not
construed as a counter offer or an act of acceptance of the original offer: the original offer still
remains and the offeree has not implicitly or explicitly accepted or rejected an offer.

Acceptance is the final and unconditional expression of interest to accept an offer and enter into
a contract. This can be done, by signing a contract or by giving verbal agreement. Within a
procurement context, it is highly recommended that verbal agreements are avoided, and
written agreements are used instead in order to maintain a clear audit trail. There must be
evidence of some form of explicit action of accepting the offer. Acceptance must be
unconditional, must mirror the offer being made, must be communicated to the offeror and
must be made within the period of validity. However, watch out for ‘acceptance by
performance’, which can arise where a supplier changes some element of contract delivery or
performance without the express permission of the buyer. Where the buyer does not query this
and simply allows it happen it could be argued by the courts that the changed terms have been
accepted by the buyer, especially if they have paid the supplier’s invoices since the changes
were made.

Some projects can be very complex, and require huge amounts of documentation and detail. In
these cases, there are likely to be inconsistencies between the documents, which may not
become obvious until they are actually implemented. As such, contracts may include an order of
precedence clause which clarifies which document takes precedence over the others in the
event of any inconsistencies.

Some contracts will call for discretion to be exercised by the relevant project or contract
manager. However, the risk associated with this is that it can lead to some uncertainty from
other stakeholders as to which documents take precedence. This is further compounded in

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large complex projects, which can run over long periods of time, where the project manager
may change.

It’s important to consider where the order of the precedence clause is located, its wording and
the construction of the contract. For example, if the clause states that the contract takes
precedence over all other documents, this would include any appendices which potentially
contradict each other. It’s therefore good practice to reference specific documents, or include
wording such as ‘this contract excluding its appendices’.

If the contract is silent on the order of precedence, then it is assumed that all documents have
equal significance.

There may be instances in a medium- to long-term contract when the original need for a
product or service that was contracted has fundamentally changed. This is most common in
employment contracts when an individual is promoted to a different role, or if they wish to
make a fundamental change to their working hours. When there are fundamental changes to
requirements, the buyer needs to follow the organisation’s contract change processes, which
usually involves contract change notices.

A contract can be changed at any time provided that the parties are able to express acceptance
to the change. In the event that an event occurs suddenly which changes the contract in
advance of acceptance, it would be reasonable to allow a window of time for any changes to be
agreed while the terms are being negotiated. In such instances, there may be an option to add
extra obligations to take corrective action in order to amend the effects of any event which
occurred that jeopardised the original contract.

In medium- and long-term contracts, it’s common practice to include a term, known as a
variation clause, that states any amendments that are made to the contract are ineffective
unless they are made in writing and signed by both parties. This term prevents either party
changing its obligations as it pleases, and it helps to provide consistency and understanding to
all parties at all times.

However, any changes in the law or regulations that apply to a particular industry need to be
considered. For example, if building regulations change partway through a construction
contract, it is good practice to have this change reflected in the contract in order to make the
performance legal. Variations look to make slight adjustments to a contract in order to make it
more relevant to the circumstances surrounding its performance as opposed to changing the
fundamental aspects.

For any variation in a contract to be effective, there must be a valid agreement between the
parties. A notification of a change is not enough. There must also be some form of
consideration to support the agreement, which may be presented as mutual surrender of
existing terms or rights, a new benefit being granted by each party to the other, or additional
benefits for the parties in the event of a breach.

When agreeing to a contract variation, a procurement professional will need to consider the
impact it will have on the rest of the contract. For example, if the contract price is reduced by a
fifth, consider whether the liquidated damages clause should also be reduced by a fifth.

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In the event that no variation clause is included in a contract, the safest approach is to
communicate with the nominated point of contact identified in the contract. Again, it’s
important that the organisation’s contract change processes are followed.

This brings us to the end of the section on the issues relating to the formation of contracts and
the associated risks.

Now answer these questions to check your understanding. Pause the podcast to write down
your answers.

1. What is the difference between an offer and an invitation to treat?

2. What happens if no order of precedence is included in a contract?

3. What is the difference between a contract change and a contract variation?

This section looks at the implications of the various elements of contractual documentation and
process on overall risk.

An indemnity is an arrangement in which one party promises to compensate another party for a
specific event, known as a trigger event. Indemnity clauses are used to help manage the risks
associated with a contract as they allow one party to be protected against any liabilities caused
by the actions or inactions of another party. An indemnity should be requested when a party is
likely to incur a loss as a result of a transaction. Or when remedies, which are available with a
damages claim, wouldn’t be sufficient to cover the loss suffered.

Indemnities are frequently used in the assignment of intellectual property rights, in software
licence agreements, and in share purchase agreements. Some losses can’t be indemnified, for
example, losses caused by the deliberate act of the receiving party, or by the receiving party’s
own crimes.

A liability is a legal responsibility rather than a professional or commercial responsibility. For

example, in employment, companies are liable for the cost of compensation for employees who
are injured at work, as there is a duty of care to look after them.

Parties will often seek to limit their liability in commercial contracts. This area is naturally the
subject of negotiations because each party will want to restrict the levels of risk their
organisation is exposed to by limiting their own liability and maximising the other party’s
liability. Common approaches to do this are to explicitly exclude liability for certain types of
losses which may occur during the contract, and putting a cap (or limitation) on the value which
a party is liable for. When drafting a clause which limits the liability of a party, contract
regulations, limitations, and exclusions and relevance should be considered.

Insurance offers a guarantee of compensation with respect to certain events, such as loss or
theft, in exchange for a premium. Such clauses are commonly used in agreements involving
distribution, licensing, manufacturing and product trials. In order to ensure the ownership of
risk falls to the relevant areas, a buyer should analyse the risks and relationships, create an
appropriate insurance and indemnities clause, and report claims promptly.

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When drafting the requirements for an insurance clause in a commercial contract, the following
should be considered: the wording, the duration, and the risks insured. The practice of risk
transfer should permit a buyer to be responsible only for the activities that they are directly
responsible for, and to allow them to focus on their operations.

One area that can potentially cause confusion is the difference between the obligations to
maintain insurance against commercial risks, and a clause which places a limitation on liability.
The obligations of these two provisions are not the same thing. If a contract contains an
obligation on a supplier, for example to maintain insurance at a defined financial level, it does
not mean that the limitation of liability under the contract is at the same amount. Where a
financial limitation on a liability is required, the contract should also clearly state in a separate
clause what the limitation is and under what circumstances it applies.

The terms guarantee and warranty are often used interchangeably in common parlance,
however, they are very different.

A guarantee is a promise to perform any actions on behalf of a party to a contract if they

become unable to fulfil them. Landlords often ask prospective tenants to provide a guarantor,
often a parent or guardian, in case they are unable to pay their rent.

Whereas a warranty is a promise to take corrective action in order to fulfil the obligations of a
contract, such as repairing an item that becomes defective shortly after sale.

A guarantee needs to be put in writing and is not recognised if agreed on an oral basis. The
written contract must be made between the guarantor and the creditor, for example, between a
parent of a tenant and a landlord rather than the debtor. This is to allow the creditor in the
agreement to deal with the guarantor in matters relating to the liabilities or debts owed by the
debtor in the separate arrangement.

Guarantees are commonly requested by a seller when there are concerns over a buyer’s ability
to fulfil their terms of a contract, such as repayment of a loan. Banks that lend money to
businesses may request personal guarantees from the directors of a company in the event that
the business defaults on a loan repayment, particularly if the business is a new start-up and
doesn’t own any significant assets.

Other elements that need to be considered include liquidated damages, payment, and delivery
and completion.

Liquidated damages set out the financial compensation that the parties agree on when the
contract is formed. They are awarded to the injured party upon a specified breach of a contract,
such as late delivery or delivery of different-quality goods compared to what was stated in the
contract. In order for liquidated damages to be enforced, the estimate of damages needs to
genuinely reflect the extent of the damage that may be caused by the breach.

Because payment facilitates the consideration of a contract, payment terms, such as when
payment is due on an invoice, are commonly negotiated, but ultimately determined by the party
with the most power. The payment terms include when payment will be due, the method of
payment, and the type of payment, for example, open account, documentary collection,
documentary credits, or advance payment. When the parties have not worked together before,

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a letter of credit can be drawn up. This is an agreement between the buyer’s bank and the
seller’s bank to transfer funds due under a contract upon presentation of valid documents,
providing a guarantee that the payment will be made if valid documentation is presented.

Delivery is considered to be achieved once the delivery terms have been met, including, for
example, the incoterms. Completion is established once the terms and conditions relating to a
contract have been met in full. Even then, the supplier might have ongoing liabilities, such as
product performance.

This brings us to the end of the section on the implications of the various elements of
contractual documentation and process on overall risk.

Now answer these questions to check your understanding. Pause the podcast to write down
your answers.

1. When should an indemnity be requested?

2. What’s the difference between a guarantee and a warranty?

3. What are liquidated damages?

This is the end of this podcast. You should now be able to:

 Identify the issues relating to the formation of contracts and the associated risks, and

 Analyse the implications of the various elements of contractual documentation and

process on overall risk.

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